Exchanges favor electronic trading, say those in the pits

(Crain's) — Chicago's floor traders are fearful that their days are numbered—and that their own company is delivering the death blow.

Chicago's floor traders, exemplars of a swashbuckling, commodity-based capitalism that has thrived here for more than 160 years, are fearful that their days are numbered—and that their own company is delivering the death blow.

CME Group Inc., which operates exchanges, has implemented a series of changes this year in pricing, hours and other areas. The details can be arcane, but the goal is to accommodate electronic trading, where more than 85 percent of CME's business is occurring.

Last week, CME imposed a new method of determining a closing price for grain futures by taking into account floor and electronic trading volumes, as opposed to just pit volume. That move led to a federal lawsuit by a group of pit traders against CME.

“I'd rather go down fighting,” says Anthony McKerr, a third-generation corn pit trader who signed onto the lawsuit. “I think what they're doing is wrong.”

Agricultural pits at the Chicago Board of Trade date back to 1848, when they were created to help merchants buy commodities at set prices and protect farmers against price swings for their crops. Traders ceded day-to-day control when the Chicago Mercantile Exchange demutualized in 2000 and the CBOT merged with the Merc in 2007 to form CME.

Chairman Terrence Duffy, who is named as a defendant, has been reluctant to say when the pits, where he once traded hog futures, will disappear. Still, CME's decision last year to sell the building where the floors are located suggests his view.

“The exchanges will keep them around only as long as they have to,” says Michael Gorham, a professor at the Illinois Institute of Technology's Stuart School of Business who was formerly a federal regulator and a CME executive.

About 2,500 traders, runners and clerks work the floors at the Board of Trade and the Merc, thousands fewer than were there 20 years ago.

CME officials decline to comment on the lawsuit or the company's relationship with floor traders. Still, CME argues in its response to the lawsuit that the federal regulatory agency that oversees it, the Commodity Futures Trading Commission, demanded the change. A CFTC spokesman declines to comment.

“The CFTC expressed concern that CBOT calculated the settlement prices for these contracts based solely on transactions that took place on its trading floor when the vast majority of transactions in those contracts took place on CBOT's electronic trading platform,” according to CME's response.

The lawsuit was brought by 24 grain pit traders and brokers who argue that CME would breach contracts with floor traders and its fiduciary duty to them if it unilaterally imposed the new method of determining a closing price. CME already has implemented the method in pits such as wheat and lumber, where trading volume was fading.

The change threatens hundreds of floor-trading jobs and will cause “a rapid, dramatic decrease in trades being sent to the plaintiffs in the 'pits,' with the result that they and the overwhelming majority of other floor traders will lose business almost immediately and will have to close their operations forever,” states the June 22 lawsuit.

Plaintiff Heather Koch, a soy pit trader, says customers threatened to stop using the pits under the new settlement price method, which affects borrowing margins and grain elevator transactions.

Corn futures pit volume Thursday was about half of what it had been on June 22 before the rule went into effect.

CME had planned to impose the closing price change on lean hog and cattle traders, too, but they won a reprieve.

“We're next and it's absolutely wrong,” says David Hill, an independent lean hog trader. “If you shift this to the screen, you're going to have extraordinarily wide settlement prices.”

Aside from arguing over the new rule, trader Mr. McKerr says the plaintiffs are “frustrated with the way the CME has been treating us.” CME battled grain traders in May after proposing to extend its electronic trading to 21 hours from 17 to compete with its archrival, Atlanta-based IntercontinentalExchange Inc., which this year jumped into the corn futures market with a 22-hour trading day. The traders said that the added hours didn't give them time to digest federal agricultural reports outside trading hours and that their customers feared it would increase costs and price volatility.

To be sure, some CME pits are still vibrant, with eurodollar futures options being the most active. And many of Chicago's biggest trading firms supplement big electronic trading desks with floor traders.

“It's unfortunate that there is friction because the policy at the CME is certainly to support all avenues of our market, both floor traders and electronic traders,” CME Chairman Emeritus Leo Melamed says. “The things that we do are best for the entire institution.”

But most industry observers say it's just a matter of time before the pits are gone.

“The Chicago trading floors will not survive five years,” says University of Chicago Booth School of Business professor George Constantinides. “The bigger question is whether the CME will stay in Chicago, given that with electronic trading they can pick up and go anywhere they please.”